On March 1, IMF Managing Director Horst Köhler announced the establishment of the International Capital Markets Department in the IMF. Below are edited excerpts from a March 2 press briefing by K&#x00F5;hler and First Deputy Managing Director Stanley Fischer on that decision and on the IMF's response to financial crises, including Turkey (www.imf.org/imfsurvey).

Is the U.S. trade deficit sustainable? On this issue, when Catherine Mann speaks, people listen. Mann, a Senior Fellow at the Institute for International Economics (IIE), is the author of an authoritative 1999 book on the issue (see her article in Finance & Development, March 2000, for a summary).

In her book, Mann predicted that U.S. trade and current account deficits, though a matter of long-term concern, were sustainable in the near term, certainly “for two or three more years.” At a March 1 talk organized by the IIE, Mann updated her analysis and said she saw no reason to change her earlier prediction that the deficits, though large, would be sustainable through 2001–02. (Mann considers the deficit to be “sustainable” in the sense that it is unlikely to generate any economic forces of its own that would bring about a significant reduction.)

Mann did caution that global investors could decide that U.S. assets account for so large a share of their portfolios that they scale back their holdings of these assets. Under such a scenario, asset prices would have to adjust to reflect this change of sentiment in global markets; most likely, the exchange value of the dollar would decline. However, she assigned a low probability to such a scenario unfolding this year.

What drives the deficits?

According to Mann, the U.S. trade and current account deficits are principally the outcomes of the stronger economic performance of the United States relative to that of its trading partners. There are two aspects to the stronger performance. First, U.S. real GDP growth over the past few years has been stronger than in its partner countries. Second, investments in U.S. assets continue to provide high returns (adjusted for risk) to global investors.

Rapid real GDP growth in the United States fuels an increase in import demand that far outstrips the growth of exports (which depends on the real GDP growth of its trading partners). As a result, the United States cannot pay for its desired imports through its exports, thereby generating large trade and current account deficits. Mann refers to this as the “real side” or the “U.S. perspective” on the deficits.

But the same transactions can be viewed from what Mann calls the “financial side” or the “global perspective.” The United States pays for its current account deficits by borrowing from the rest of the world. This borrowing is reflected in an accumulation of U.S. assets in the hands of global investors. The fact that the United States continues to provide high risk adjusted returns to these investors is critical to the country’s continued ability to fund large current account deficits.

The issue of the sustainability of current account deficits can therefore be viewed from either the real side or the financial side. At the end of the day, these are “two sides of the same coin” and cannot diverge. But the pressures for adjustment in the deficit could come from either side.

U.S. current account deficit

Data: Catherine Mann, IIE

Real-side estimates

Mann presented updated estimates of the U.S. current account deficit based on a standard econometric analysis of import and export equations. She also presented an alternative set of estimates for 2001–02, which are based on a modification of the standard analysis to take account of the more rapid technological change of the last few years (the “New Economy” phenomenon) and trends in the liberalization of trade in services.

Mann’s estimates (see chart) are that the U.S. current account deficit in 2002 would be just over 5 percent of GDP under the standard analysis, and 4¼ percent of GDP under the modified analysis.

Though the deficits would continue to be large, Mann felt that—viewed from the real side—they were sustainable for a number of reasons. First, high productivity growth in the United States provides reassurance that the United States will “make good on the expectations” of strong economic performance. Second, the payments associated with the borrowing needed to finance the deficit are still small relative to the size of the U.S. economy; Mann described them as “being a small credit card payment to make each month on a very large income.” Third, the nature of the financing of the U.S. deficit buys it some time before the inevitable pressures to adjust. The United States borrows almost exclusively in domestic currency; more than 90 percent of its external debt to banks is in dollars. In addition, most of the private capital flowing into the United States consists of foreign direct investment and portfolio investment, rather than bank lending. All told, the United States can afford to carry a larger external deficit than a country whose obligations consist primarily of contractually fixed, short–term bank loans denominated in foreign currencies.

Financial side worries?

Mann injected a note of caution, however, by suggesting that the same deficit, viewed from the financial side, does raise some doubt about its sustainability. The flip side of a continued U.S. trade deficit is the growing share of U.S. assets in the portfolios of global investors. These investors could reach a point where—for reasons of diversification—they are no longer willing to absorb U.S. assets. These concerns would be heightened if investors chose to replace the shrinking supply of U.S. government debt instruments in their portfolios not with other U.S. assets but with the assets of other governments.. If a scaling back of demand for U.S. assets does take place on the financial side of the coin, it would have to be reflected also on the real side. The most likely adjustment would be a decline in the value of the dollar, which would lower the current account deficit by making U.S. imports more expensive and U.S. exports more competitive. While suggesting that this was a scenario to keep in mind, Mann did not think it likely that it would unfold in 2001.